Back in the spring of 2018, yours truly responded at length to a speech then New York Fed President Bill Dudley gave, defending the Fed’s “floor” system of monetary control. In that speech, Dudley claimed that “the case for retaining the current floor system is very compelling.” A floor system, Dudley said, “is operationally much less complex than a corridor system” since “the setting of IOER is largely sufficient to maintain the federal funds rate within the FOMC’s target range.”
Mr. Dudley retired a couple months after giving that speech; and since 2019 he has been a senior research scholar at Princeton’s Griswold Center for Economic Policy Studies. I have no idea exactly what such a research scholar does; but unless those duties included hiding under a rock, Mr. Dudley is surely aware of goings on in the money market of late. Yet in a recent Bloomberg op-ed, he once again claims that the post-2008 floor system “is much simpler to carry out” than a corridor arrangement. Only he now adds that this is so, “provided there are sufficient reserves in the system.”
But that proviso is hardly the minor qualification Dudley makes it out to be. Instead, after more than a decade the Fed has yet to determine how many reserves are “sufficient.” And despite what Dudley claims, it is far from obvious that adding more reserves to the system will prove capable of smoothing what he blandly describes as “a few bumps in the road” toward a floor system that works in practice the way it’s supposed to work in theory. Instead, as Bill Nelson observed at a December Brookings event, the Fed could well end up discovering, as Norges Bank did a few years back, that under a floor system the demand for bank reserves tends eventually to catch-up to the supply, making the effort to satiate the banking system with reserves once and for all as futile as a dog’s effort to catch its own tail.
Nor is that all that’s wrong with Dudley’s claim. In theory, as he notes in 2016, setting the central bank policy rate under a floor system is a simple matter of flooding the system with reserves and then setting the rate of interest on reserves at the desired policy rate. But even when reserves were presumably abundant, the Fed’s floor system never worked as planned. From the first the fed funds rate sagged below the IOER rate, compelling Fed officials to switch from a single-valued rate target to a target “range.” Then, to keep the rate below the lower limit as that limit was raised above zero, they had to establish an overnight reverse-repurchase facility. Next, as the funds rate tended to creep up within the designated target range, they had to keep adding space between the IOER rate and the target upper limit. Finally, as they encountered those “bumps” along the road, they had to undertake (“forward”) repo operations amounting to hundreds of billions of dollars—operations that are likely to continue for some time, if not indefinitely, despite the Fed’s concurrent, permanent additions to the stock of bank reserves. In short, there appears to be a lot more to the U.S. money market than Mr. Dudley and other proponents of the floor system dream of in their philosophy.
And now the Fed is contemplating—and Mr. Dudley is himself championing—a standing repo facility which, whatever its merits, will add still another layer of complexity to an already far from simple operating system.
Finally, to pick one last nit, whether it was chosen by Mr. Dudley or not, the title of Mr. Dudley’s op-ed (“The Fed Should Keep Looking Forward, Not Retreat to the Past”) does critics of the Fed’s floor system an injustice. The alternative most expert critics of the Fed’s floor system have in mind isn’t a “retreat” to anything. They aren’t recommending a return to the pre-October 2008 status quo. Nor are they suggesting that the Fed should dispense with interest on reserves. Instead, they’d like to see the Fed move toward a standard “corridor” operating system, with interest on reserves determining the corridor’s lower limit, and a standing lending facility—repo or otherwise—setting the upper limit. This is a tried-and-true system employed by many of the world’s central banks. Yet the Fed itself has yet to try it.
Finally, as for which group is being more forward looking, ask me again when the Fed’s balance sheet hits $6 trillion or, better still, after we witness the first round of Green QE.
